Battle Of The Preferred CEFs: Sell PFD, Buy FLC (NYSE:FLC) (NYSE:PFD)

We have covered funds from the Flaherty & Crumrine family quite a number of times, even giving a shout out to our readers about the free lunches to be had from their fund buffet. With 2022 coming to a close, we see another such opportunity which we share below.

Flaherty & Crumrine Preferred and Income Fund (NYSE:PFD) is a closed end fund [CEF] with an objective to provide its investors with high current income while preserving capital along the way. While one can read the fine print of their investment objectives and strategies in detail on their website, broadly speaking PFD aims to achieve its objective by investing at least 80% of its assets in preferred and other income producing securities.

Flaherty & Crumrine/Claymore Total Return Fund (FLC) is a CEF that states in its fact card that earning high current income for its investors is its primary objective. Being a total return fund as indicated in its name, capital appreciation does come in as the next objective. Just like PFD, the Flaherty website provides loads of details on FLC’s objectives and strategies. This CEF aims to achieve its investment goals by investing at least 80% of its total assets in preferred shares, debt and other income producing securities.

While FLC has more assets under management [AUM] than PFD, both are far from the largest in that family as can be seen below.

Both employ leverage and the latest numbers show them to be in the same ballpark.

While leverage enhances investment returns when costs to borrow are low, it does the opposite when rates are high. The higher costs feed on the already hurting NAV due to the poor performance of underlying investments. In the case of our two funds, as we can see that the annualized expense ratio for the six months ended May 31, 2022 is quite a bit higher than the previous year:

These move with a lag so the May 31, 2022 numbers don’t come close to telling the whole story.

Leverage costs, which for the Fund are currently 1-month LIBOR + 0.80%, reset monthly, remained low throughout 2020 and 2021. Leverage costs have increased rapidly this year, consistent with the Fed’s more-aggressive path for rate hikes.

By the beginning of 2023, we are looking at a 5.75%-6.00% rate on its borrowing which should push total expense ratio well past 3% factoring in leverage.

Both the funds invest primarily in the financial sector, and that is the case for most preferred share funds. One can again see the relative identical sector allocations between the funds.

The Macro Call

Preferred shares are getting quite attractive and, in many cases, have discounted far higher long term interest rates than what are likely. For our portfolio, we have stuck with individual picks as we are still not at the point where we are ready for CEFs employing leverage. We still think these two funds we discuss, will deliver solid returns over the next 12-24 months but we “prefer” one over the other.

Where Lies Your Alpha?

While the funds do look identical, they also do the more important thing. Perform in an identical manner. When we say identical of course, we are referring to movements at a Net Asset Value level. Here are the two over the past five years.

Sure, you can briefly see daylight between them, once or twice but they appear to be Siamese twins for the bulk of their journey. That of course gets us to our alpha part. FLC trades at a 7.5% discount while PFD trades at a 1.8% premium.

That is a stunning difference for two virtually identical funds. You can see the other three funds from the same family as well and there is really no reason to pay a premium for PFD when all others are available discounted. We chose FLC for our comparative here as it has the widest spread. One other interesting aspect of this premium/discount spread is just how often this happens. To show you this we plotted the spread between PFD’s valuation to FLC’s. Currently, this stands at 9.39%.

What is fascinating is that you get at least one chance every year when the spread compresses to 0% and then reverts back with vengeance. If you sold PFD and bought FLC every time you got a 9% spread and then sold FLC and bought PFD every time you got a 0-1% spread, you would easily add the equivalent of your distributions, every single year. You have one such opportunity again and investors should capitalize on this.

Please note that this is not financial advice. It may seem like it, sound like it, but surprisingly, it is not. Investors are expected to do their own due diligence and consult with a professional who knows their objectives and constraints. We strongly recommend you have a Merry Christmas and a Happy New Year.